World Bank Warns of Economic Crisis in China; Only 3% Growth for Decade Says Michael Pettis

A World Bank report to be released next week warns of an economic crisis in China unless state-run firms are scaled back. The Wall Street Journal discusses the report in New Push for Reform in China
An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation's leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.

"China 2030," a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China's most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.

The report warns that China's growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the "middle-income trap." A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.

It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.China's Difficult Transition From an Unsustainable Growth Model

Peak oil, a housing bubble, bad debts and over-reliance on investments with no genuine economic feasibility guarantee China's current boom is not sustainable. China bulls are in for a ride awakening when various bubbles pop.

As for recommendations, the report proposes a sharp increase in the dividends that state companies pay their owner (the government) in order to boost revenue and pay for new social programs.

Does China need to increase competition, break apart, and privatize the state-owned monopolies?
Or should China simply increase the dividends?

I vote for the former as does Michael Pettis at China Financial Markets.

Via email, Pettis says:
The report is good as far as it goes, but it doesn’t go far enough. Of course increasing SOE dividends to the government for use in social programs will transfer wealth from the state sector to the household sector, but if the total profitability of the SOE sector is less than one-fifth to one-eighth of the direct and indirect subsidies transferred from the household sector, as I have argued many times, then even 100% dividends is not enough to slow the transfer significantly, and remember the transfers have to be reversed, not merely slowed. This proposal falls in the better-than-nothing category, but just.

What we really need are much more dramatic transfers, for example wholesale selling of assets, with the money used either to clean up bad loans or delivered directly to households. According to the article, however, “neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.”

This is the problem. The best solution for China, economically, seems to be off limits because it will be politically difficult. In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.

And how much will growth slow? The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years.

That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.

And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall. With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today. Chinese investment demand simply cannot hold up much longer.Sad State of Political Acceptability

The report makes feeble recommendations to ensure the proposals are "politically correct". This is a bad practice for three reasons.

You only damage your own credibility

You presume perhaps incorrectly what is politically acceptable

You plant false hope that incorrect solutions will work, when it's clear they will not

It would be far better list the alternatives and the limitations of those alternatives, then provide an honest assessment rather than assume something cannot be done. Unfortunately, telling people what they want and expect to hear is the sad state of political pandering everywhere.

Related

With manufacturing and non-manufacturing PMIs disappointing, and the nation's banking system still stuck in the thralls of a liquidity crisis (each time the PBOC removes the punchbowl), Michael Pettis' warnings are becoming increasingly likely (even though consensus remai

The World Bank has slashed its growth forecast for China's economy this year to 7.7 percent from 8.4 percent, warning of a potential "sharp" slowdown triggered by a fall in investment. The projection is lower than the 7.8 percent expansion the country recorded in 2012, which was its weakest in 13 years, and comes as a slew of data indicate the economy is struggling to pick up pace.

I am saddened to report that Michael Pettis' site China Financial Markets has been blocked. The link redirects to a site with a one line message "This Account Has Been Suspended". When I have more details, I will post them.
This is really a shame because Pettis is invariably a great read. I am personally indebted because he has taught me most of what I know about trade.
Michael Pettis is Professor of Finance at Peking University, and Senior Associate at the Carnegie Endowment for International Peace.

Bankruptcies Rock Loan Guarantors In China, loan guarantors are going bust at a sharp pace. Many more bankruptcies are on the way. The setup is quite reminiscent of the implosion of credit insurers Ambac and MBIA during the US housing bust.

Emerging markets risk an interest rate shock once the U.S. Federal Reserve and other Western authorities start to withdraw global liquidity, the World Bank has warned.
“There is the risk that the transition to higher rates occurs in an abrupt and disruptive fashion. In such a scenario, markets react pre-emptively, potentially trapping some participants in vulnerable positions that appeared manageable under low interest rates.”

China could face an economic crisis if it does not implement major reforms in the next 20 years, the Wall Street Journal said Thursday, citing a report by the World Bank and Chinese government researchers.The "China 2030" report -- to be released Monday -- warns economic growth is at risk of a sharp and sudden slowdown, which could trigger a severe downturn in the world's second-largest economy, the paper said.

Everyone is in awe of China's economy. Its prodigious exports, heroic rates of investment and colossal foreign reserves are both deeply impressive and a little intimidating. China's economic policymakers are a competent, confident bunch. Even they, however, worry about the fabled "middle-income trap", the tendency for fast-developing countries to slow dramatically when their per capita GDP reaches middle-income levels.